Five of the Biggest ETF Myths

1) Myth: “When I buy an ETF, the ETF Trust has to go out and buy the underlying portfolio/commodity/etc“

Truth: When you buy an ETF, the ETF does not take your money and go out and buy their underlying portfolio with it. You buy from someone in the marketplace. This is true no matter what ETF you’re talking about – SPY, QQQQ, GLD, SLV, PSLV, IWM, etc.

When you buy IBM stock, IBM doesn’t get your money, and when you buy SPY, the SPY Trust doesn’t get your money. The person who sells you the security gets the money. (caveat – unless you are participating in a secondary offering)

2) Myth: “ETFs are too hard to understand.“

Truth: Most ETFs are not very complex, devious, or hard to understand. Don’t be afraid to pick up a prospectus – they are all extremely detailed and thorough about explaining how the product works, and most of the ETF providers have simplified explanations with examples on their websites.

“I can’t stress the complexity of the structure. If the very nature of these “creation units” is beyond the comprehension of most investors the actual mechanics of ETFs involve an even far more complex matrix of transactions.”

One of the great things about ETFs is that they can be created and redeemed. This means that “authorized participants” (read: big broker dealers) can take a basket containing the underlying stocks of the ETF, in specific weights, deliver them to the ETF trust and receive the ETF shares – that’s called creating. They can also do the opposite: deliver the ETF itself to the trust, and receive the underlying basket of individual stocks – that’s called redeeming.

You take a basket of stocks and give it to the Trust – they give you the ETF. Or, you take the ETF and give it to the trust – they give you the basket of stocks. WTF is complex about that?

If “the market” is lacking SPY sellers, and the price of SPY rises so that it is in excess of it’s NAV (net asset value) there are arbitrageurs standing by ready to short you shares of SPY while they simultaneously buy the underlying basket of SPY components as a hedge. Since they are selling SPY “rich” to it’s fair value, they will make a profit when they eventually collapse their position. How do they collapse it? Well, they take their long basket of SPY component stocks and “create” SPY by delivering the individual stocks to the trust, receive newly created SPY, and use that to cover their SPY short position. Voila – they’re now flat, and the SPY’s assets have increased, as have the shares outstanding.

Of course, if everyone wants to sell SPY, the opposite happens – the arbitrageurs, if SPY is trading “cheap” to it’s NAV, will buy SPY while simultaneously shorting a basket of the underlying components. Then, they’ll take their SPY shares, deliver them to the trust, redeeming them for the underlying components which they use to close out their short underlying stock positions. In this case, the assets held by the trust decrease, as do the shares outstanding (after all, the arbs have taken SPY shares out of circulation, and given them back to the trust, effectively “retiring” the shares temporarily.)

4) Myth: “I can tell from the premium of my closed end fund that it means that The Market thinks * fill in the blank*“

Truth: when looking at a closed end fund, especially one that is difficult to borrow and short, you can’t draw conclusions about what the premium/discount to NAV might mean, because “The Market” cannot correct mispricings. When the market cannot correct mispricings, you can’t draw “The Market thinks xxxx” conclusions.

Repeat after me: PSLV’s 20% premium to NAV is NOT an indication of supply shortages in the silver market. PSLV’s 20% premium is NOT an indication of the true cost of “physical” silver. Seriously, folks, use your heads. PSLV is a closed end fund without any means to arbitrage price discrepancies. That’s it – that’s pretty much all you need to know. There’s no way for traders to create more shares by delivering silver bullion to the trust (like SLV’s creation process), and there’s no borrow available for traders to short PSLV when it gets away from its Net Asset Value.

The Market can’t do anything about the overpricing!

5) Myth: “Ultra ETFs don’t do what they are supposed to do – I looked at a 2 year chart of XLF (financial ETF) and SKF (ultrashort financial ETF) and they were both down over the period!“

Truth: Most Ultra-Etfs do a very good job of their exact stated goal, which is one day leveraged performance relative to the underlying basket. It’s a mathematical truth that compounded daily returns do not equal compounded long term returns, which is why SKF can return -200% of XLF on a daily basis as designed, and yet not return -200% of XLF on a longer term basis.

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